No-One Knows Anything Any More

The most interesting thing we learnt at London Sugar Week 2018 was that most people are no longer bearish.
Perhaps this isn’t surprising. The No.11 market is more than 30% higher than the recent lows. After weeks
of waiting for news on Indian subsidised exports, speculative short positions have been covered. We also
didn’t meet anyone who was bullish, so it seems people are looking for direction.

We remain negative on price. We struggle to see why raw sugar prices should approach 15c again. If anything we think they
should be closer to 10c. Global sugar stocks are the highest they’ve ever been. We also think that it is
easy to understate how difficult it will be for India to export 5m tonnes of sugar when world sugar stocks
are this high. We’re talking about increasing global sugar supply by 10%, but we don’t actually need a
single additional tonne.

Higher prices also risk locking in sugar production that is not needed. To examine this in more detail, we have decided to
look at the problem of sugar overproduction. Have producers changed their behaviour? Was 10c enough to
resolve the sugar surplus?

There is Too Much Sugar

In the 2017/18 season, global sugar production exceeded 200m tonnes
(raw value)
for the first time. For the 2018/19 season that’s just begun we think production will remain close to this level.

Global Sugar Production Has Hit 200m Tonnes (RV)

This poses a problem. If production remains at 200m tonnes it’s going to take consumption 6 years to catch up. If we are
to avoid building sugar stocks to 2024, we need to see someone respond to lower prices and change behaviour.
Who?

Does This Mean 6 More Years of Surplus?

Sugar production is dominated by a handful of countries, so it makes sense to concentrate on these. The major producers of
sugar are India, Centre-South Brazil, the EU, NAFTA (now called USMCA), Thailand, and China.

In Which Countries Might Behaviour Change?

We’re going to leave USMCA to one side; its interaction with the world market is small. We can split the remaining countries
into two categories: countries where farmers are unlikely to switch from sugar cane growth and countries
where farmers’ planting decisions will be important.

India

Let’s start with a blunt statement: it’s difficult to see why Indian cane area should shrink.

Cane prices are set by the government. They are set at a level which gives farmers a good return. The reason is political.
Cane farmers are an important source of votes in sugar cane regions in the north and west of the country.
In addition, the mills where the farmers’ cane is crushed are often owned by politicians or aspiring politicians.

India – Cane Returns are Excellent

The relationship between the mills/politicians and the farmers runs into difficulty when mills can’t afford to pay farmers
on time for their cane. This typically happens in surplus seasons when sugar prices are too low to make
cane payments. However, presently the ex-mill sugar price is fixed close to cost of production. While mills
are definitely struggling, especially given working capital requirements ahead of the start of cane processing
in November, cane arrears are below where they would otherwise be.

As well as fixing the domestic price the government is clearly doing everything it can to support payments to the farmer,
including a cane subsidy and a sugar transport subsidy for export. These are likely to be challenged at
the WTO by other sugar producers in the coming weeks. However, the level of government support to the farmer
means it’s very unlikely cane prices will fall in the coming years. Farmers will therefore continue to
grow cane and acreage is therefore unlikely to fall. Indian sucrose output is therefore in the hands of
the weather.

This means we’re locked into producing a certain amount of sucrose, equivalent to more than 30m tonnes of sugar indefinitely.
This will ensure India remains in surplus for the foreseeable future, which isn’t good news.

The Indian government has recognised that overproduction of sugar won’t go away. If they won’t link cane and sugar prices
and can’t reliably (or profitably) export, then sugar stocks will continue to build in India, creating
a financial burden for the government. As a result, the government is looking at how to manage this problem.

As Brazil shows, sugarcane is an energy crop. India imports almost all of its liquid transport fuels. When oil prices are
high and the Rupee is low this puts pressure on the economy. Making more ethanol from cane is one way to
relieve this pressure, while also increasing energy security.

India already has a 5% ethanol mandate, which has never been met. Differences in taxation across states have made it difficult
to move ethanol around the country, which has made it hard for oil companies to procure what they need.
They have also frequently been outbid by the potable and industrial ethanol sectors. Meanwhile, mills have
only been allowed to make ethanol from low sucrose C Molasses, which is normally otherwise used as animal
feed.

This year the government has announced measures to encourage mills to make more ethanol and also to encourage the oil industry
to buy it. Mills are now allowed to use higher-sucrose B Molasses to make ethanol. They will also be able
to use cane juice directly, as in Brazil, though this is likely to need new investment in distilleries
and so won’t be an immediate solution.

Import regulations have been changing too. Ethanol can be imported for potable and industrial use, but can no longer be imported
for fuel use. This pushes the oil companies to buy ethanol from sugar mills instead. Finally, ethanol prices
have been fixed at levels which make it profitable for mills, especially if they use B Molasses as a feedstock.

India – Move to B Molasses to Make Ethanol Will Reduce Sugar Production

We think this means that India is far more likely to reach its 5% ethanol in gasoline blend target, and that mills will increase
their output of ethanol. We are already seeing increased use of B Molasses to make ethanol. We think this
will result in 350k tonnes less sugar production this coming season, and perhaps up to 750k tonnes less
the following year. Once cane juice distilleries are built, these numbers could grow further.

However, all of these measures are driven by changes to Indian regulations, not by the price of sugar. So we’ll move onto
the world’s second largest sugar producer, Centre-South Brazil, to see if price is changing behaviour here.

CS Brazil

Mills in CS Brazil choose whether to make sugar or ethanol based on which gives the best return. For the current season the
relative returns have been hugely in favour of ethanol, and mills have responded by diverting the highest
proportion of cane juice to ethanol production since 1997.

CS Brazil – Close to Maximum Ethanol Mix

This year has shown us how effective the CS Brazilian mills can be at debottlenecking their ethanol operations. The sector
has achieved ethanol output beyond what we thought was possible; we’d originally forecast the ethanol mix
at 60%. We think this trend could continue next year. Assuming a normal weather, sugar concentration is
likely to be lower, which favours ethanol production. Furthermore, lower cane volumes should allow mills
to flex more output to ethanol by slowing down the cane crushing rate. We’ve also heard rumours of more
efficient enzymes used in the fermentation process. So we are very tentatively assuming that we could see
further sugar lost next season to ethanol production.

This outlook assumes no wild moves in FX, that oil prices remain high and that Petrobras don’t change their existing world-energy-market-linked
pricing policy. The second round of voting for the Brazilian presidential elections (28th October) could
be a source of volatility in the FX and could lead to a change in Petrobras’ policy depending on the result.
Moreover, sugar becomes a more attractive product for the mills again at 15c (based on today’s ethanol
prices). If the raw sugar market rallies above this level, we should assume more sugar production in 2019.

We are also assuming that CS Brazilian cane acreage won’t really change in 2019. It’s worth examining this assumption in
a little more detail, particularly given recent news articles that soy is offering some farmers superior
returns.

This story sounds credible; No.11 raw sugar prices have been at 10-year lows while Brazilian soybean physical values have
benefitted from the USA-China trade dispute and the banning of US soy imports by China.

CS Brazil – Cane Still Favoured

However, we think that we are unlikely to see a meaningful reduction in cane area in CS Brazil. Competition between grains
and cane is most pronounced in the frontier states of Goias (GO), Mato Grosso (MT) and Mato Grosso do Sul
(MS), not the cane heartlands of Sao Paulo (SP) and Parana (PR). These frontier states also have the highest
proportion of mill-owned (not farmer-owned) cane. Sugar mills are unlikely to replace their own cane with
other crops because this risks reduced mill throughput, increasing inefficiency and driving up costs relative
to output.

We also calculate that for many mills and farmers, cane is competitive versus soy. This is because the Consecana cane formula
takes into account ethanol returns as well as domestic and world market sugar returns, and these ethanol
returns are positive. Don’t forget that cane is a less intensive crop to grow than soy or corn.

However, third-party cane farmers do have another consideration: the CS Brazilian milling sector is financially distressed,
and so farmers aren’t guaranteed to be paid on time or in full for their cane. If cane payments are late
or incomplete it is possible we see some farmers divert a little acreage. Another determinant factor is
mills closure. If a mill shuts down entirely due to bankruptcy, third-party farmers have to supply cane
to a different mill or grow a different crop.

We therefore don’t think CS Brazilian cane acreage will decline significantly in the future. What matters is that the mills
continue to operate and continue to maximise ethanol output.

Let’s now look at the next tier of major global sugar producers. In contrast with India and CS Brazil, we believe that current
prices are changing farmers’ planting decisions in Europe, Thailand and China.

The EU

European sugar is made from beet, not cane. Beet is an annual crop with a short growing cycle, which means that farmers can
respond very quickly to changes in returns.

The European sugar sector was deregulated in October 2017. From this date sugar production and trade were no longer heavily
controlled by the European Commission. Many beet processors signed three-year beet supply deals with farmers
to ensure resource through this period. These deals were made when the price of sugar was significantly
higher than it is today, and so recent farmer returns from beet have been excellent. However, beet processors
have done less well as they have faced falling sugar returns.

EU – Crop Returns in the Uk in 2018…

This will change in 2019. Three-year beet deals start to expire and the contracts farmers are being offered pay a lot less
for beet. For example, we calculate that in the UK in 2018 sugar beet was the crop with the highest gross
margin for farmers, and also provided a decent net margin. In 2019, the returns are lower, which might
lead to reduced acreage. One reason is that the beet price is going to fall by almost 10%. Another reason
is the ban on neonicotinoid pesticides which will come into place. This will probably lead to a drop in
yields or an increase in spraying costs.

…And in 2019

European sugar production therefore looks set to fall, and this is unlikely to change until beet processors can offer a higher
beet price. This requires an increase in the world sugar market price.

Thailand

Farmer returns are also under pressure is Thailand. For years sugar cane has been the best returning crop, a consequence
of good world market prices and additional support from the government via the Thai Sugar Fund and loans
from agricultural banks.

However, world sugar prices have collapsed at the same time as the Thai sugar sector has been reformed under threat from
a Brazilian WTO complaint. In the past domestic prices were fixed at profitable levels. Nowadays, they
are floating and likely to converge with the world market.

Thailand – Cane Returns Collapse

This means sugar cane is about to become a negative margin crop for many farmers. Cane prices are still driven by the world
market hedging levels the Thai Cane and Sugar Corporation achieves. If the TCSC can achieve an average
hedge of 13c/lb for 2019, farmers could lose money growing cane. If they can hedge at 14c, farmers will
break even. However, crops like cassava and corn are offering better returns today. We are likely to lose
cane acreage to other crops unless the world market trades significantly above 14c.

China

We also believe we will see a reduction in cane acreage in China in 2019, because we expect cane prices fall. However, unlike
in Thailand, Chinese cane prices are not linked to the world market. The sugar sector in China is heavily
controlled by the government. China is a deficit sugar producer, and imports are restricted. This supports
the domestic price at a level far above the cost of production, so farmers can be paid a high price for
cane without bankrupting local sugar mills. However, this policy has been undermined by smuggling of sugar
into China.

Chinese Cane Prices Look Set To Fall

The scale of the smuggling is huge; it’s one of the largest flows of sugar in the world at around 2.5m tonnes a year. This
has forced the government to look at alternative ways to support cane farmers. One proposal is that the
government could make direct support payments to farmers and so allow the domestic price to fall. However,
direct payments are unlikely to be made before 2020, and so in the short and medium term high domestic
prices look set to continue. Meanwhile, local mills are struggling to compete with smugglers. Domestic
prices are not high enough to make the milling sector profitable. Mills are therefore campaigning for lower
cane prices to help them break even. If cane prices fall, farmers will lose money and we could see either
a reduction in cane acreage or an increase in intercropping cane with other crops, such as watermelons.

China – Cane Farmer Returns will More Than Halve

In summary, we don’t expect to see a large decline in Indian or CS Brazilian cane acreage in the coming years. However, we
should see beet acreage fall in the EU, and cane acreage retreat in Thailand and China. In addition, ethanol
production from cane is likely to grow in importance if oil prices remain high and sugar prices remain
low. So perhaps behaviour is starting to change after all. Is this going to be sufficient to move the market
back to a deficit?

A Return to Sugar Production Deficit, or Continued Oversupply?

The following chart shows whether the world is producing too much or too little sugar each year. The 2017/18 season had record
oversupply. 2018/19 also has a large surplus. This means global sugar stocks are building rapidly, which
is one of the reasons sugar prices are so weak.

The Situation Today

We have had more surplus than deficit years since 2008, and the surpluses are getting larger while the deficits are getting
smaller. If we take the 2018/19 stocks and apply all of the changes which we’ve discussed in this report,
2019/20 stocks will remain above the levels seen before this most recent stock build.

2019/20 - Stocks Still High

This outlook is interesting because it suggests we may not add to global sugar stocks in 2020, which is four years sooner
than if we’d had to rely on consumption growth alone. However, a balanced market still leaves the problem
of what to do with the huge stocks which have built in 2017 and 2018. These stocks will continue to hang
over the market in the coming years unless production falls below consumption. For this to happen we need
a further event: perhaps poor weather disrupting cane or beet crops, or logistical disruption at a key
sugar supplier. Without this, the market will remain weak.

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